How To Use FX Risk Reversals In Your Analysis
Risk reversals are used to protect or hedge a position in the market. This video shows you how to use it in your analysis...
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We have a great question from a new subscriber who says they are aware of what implied volatility is and how to use it in their trading, but they are not familiar with risk reversals and just wants some more detail on what it is and how they can use it in their analysis.
I know you said you are already familiar with implied vol, but just for the sake of the rest of the community I’ll just quickly explain what it is and how we use it because it is important to understand that first in the context of risk reversals as well.
Let me open up the chart that I used in the video today, the chart was for the GBPUSD, and on this chart we have four lines. The bottom two is the 1-month and 3-month implied volatility for the GBPUSD, and the two lines above that is the 1-month and 3-month 25-delta risk reversals.
Now, starting with implied volatility, it sounds really fancy but to break it down real simply, the implied volatility for any asset is simply the amount of uncertainty that the options market is pricing in for a particular asset in a specific time horizon. So, for example, the 1-month implied volatility for the GBPUSD reflects the amount of uncertainty the options market is pricing in for the pair in the next month.
Whether you are looking at 1-week or 1-month or 12-month implied volatility, you are essentially seeing what amount of uncertainty the market is placing on that particular asset in that particular time horizon. It’s also important to remember that it’s not set in stone, it will fluctuate as the spot price fluctuates and as perceived uncertainty increase and decreases.
Now as you know, there is usually an inverse relationship between volatility and price, but that doesn’t always mean there is a lead-lag relationship, as the implied uncertainty can change as the spot price changes, but thinking of it as an inverse correlation between volatility and price will suffice for the video.
Taking a look at the risk reversal, what exactly is it. Well there is a difference between a risk reversal strategy, which means you are buying a call and a similar delta put at the same time as a hedging strategy, but we aren’t referring to the risk reversal strategy here, we are referring to risk reversals as the difference between out of the money calls and out of the money puts of the same delta, in the example that we are using on the chart we are looking at the difference between the 25 delta call and the 25 delta put.
Because we are looking at the difference between the volatility of a similar call and put, we are essentially seeing what the balance of risks are between a big upside move in the currency pair or a big downside move in the currency pair. Remember that more calls in a market means there is more bullish expectations, and more puts means there is more bearish expectations.
When risk reversals are moving higher, it means that call options are more expensive than put options, which means that upside protection is getting more expensive, and if the risk reversal is moving lower, it means that put options are more expensive than call options, which means that downside protection is getting more expensive.
A very big and positive move of a risk reversal shows that the options market is pricing in a higher probability that the pair moves higher, where a very big and negative move of a risk reversal implies that the options market is pricing in a higher probability that the pair moves lower.
Another way to look at this is by looking at a volatility smile, for those of you who has access to Metastock Xenith you can access their FX volatility app that shows the vol smile. The smile has the ATM option in the middle, and as the delta’s decrease and you get further away from the current spot that obviously means there is more uncertainty about where price will be the further you move away in time, and if the smile shifts more to the left, that usually means more demand for puts and is usually more of a bearish outlook or expectation, and as the smile shifts more the right, that usually means more demand for calls and is usually more of a bullish outlook or expectation.
So, if you see risk reversals are titled to the downside, or you see the vol smile tilted to the left, that means that there is more demand for puts and means that downside protection is increasing.
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If you find this content helpful, you’ll love Financial Source.
There’s a link below were you can learn more about it
https://financialsource.co
----
We interpret and explain price moves in real-time, 24 hours a day. Our team of analysts produce text, video and audio commentary.
You understand the markets and trade with confidence. Learn more at our website here: https://financialsource.co
-----
We have a great question from a new subscriber who says they are aware of what implied volatility is and how to use it in their trading, but they are not familiar with risk reversals and just wants some more detail on what it is and how they can use it in their analysis.
I know you said you are already familiar with implied vol, but just for the sake of the rest of the community I’ll just quickly explain what it is and how we use it because it is important to understand that first in the context of risk reversals as well.
Let me open up the chart that I used in the video today, the chart was for the GBPUSD, and on this chart we have four lines. The bottom two is the 1-month and 3-month implied volatility for the GBPUSD, and the two lines above that is the 1-month and 3-month 25-delta risk reversals.
Now, starting with implied volatility, it sounds really fancy but to break it down real simply, the implied volatility for any asset is simply the amount of uncertainty that the options market is pricing in for a particular asset in a specific time horizon. So, for example, the 1-month implied volatility for the GBPUSD reflects the amount of uncertainty the options market is pricing in for the pair in the next month.
Whether you are looking at 1-week or 1-month or 12-month implied volatility, you are essentially seeing what amount of uncertainty the market is placing on that particular asset in that particular time horizon. It’s also important to remember that it’s not set in stone, it will fluctuate as the spot price fluctuates and as perceived uncertainty increase and decreases.
Now as you know, there is usually an inverse relationship between volatility and price, but that doesn’t always mean there is a lead-lag relationship, as the implied uncertainty can change as the spot price changes, but thinking of it as an inverse correlation between volatility and price will suffice for the video.
Taking a look at the risk reversal, what exactly is it. Well there is a difference between a risk reversal strategy, which means you are buying a call and a similar delta put at the same time as a hedging strategy, but we aren’t referring to the risk reversal strategy here, we are referring to risk reversals as the difference between out of the money calls and out of the money puts of the same delta, in the example that we are using on the chart we are looking at the difference between the 25 delta call and the 25 delta put.
Because we are looking at the difference between the volatility of a similar call and put, we are essentially seeing what the balance of risks are between a big upside move in the currency pair or a big downside move in the currency pair. Remember that more calls in a market means there is more bullish expectations, and more puts means there is more bearish expectations.
When risk reversals are moving higher, it means that call options are more expensive than put options, which means that upside protection is getting more expensive, and if the risk reversal is moving lower, it means that put options are more expensive than call options, which means that downside protection is getting more expensive.
A very big and positive move of a risk reversal shows that the options market is pricing in a higher probability that the pair moves higher, where a very big and negative move of a risk reversal implies that the options market is pricing in a higher probability that the pair moves lower.
Another way to look at this is by looking at a volatility smile, for those of you who has access to Metastock Xenith you can access their FX volatility app that shows the vol smile. The smile has the ATM option in the middle, and as the delta’s decrease and you get further away from the current spot that obviously means there is more uncertainty about where price will be the further you move away in time, and if the smile shifts more to the left, that usually means more demand for puts and is usually more of a bearish outlook or expectation, and as the smile shifts more the right, that usually means more demand for calls and is usually more of a bullish outlook or expectation.
So, if you see risk reversals are titled to the downside, or you see the vol smile tilted to the left, that means that there is more demand for puts and means that downside protection is increasing.
-----
If you find this content helpful, you’ll love Financial Source.
There’s a link below were you can learn more about it
https://financialsource.co
